Why Does Momentum Investing Work?

By Brendan Conway

It’s been called the “idiot strategy”: Buying stocks which have risen in price, purely because they’ve risen in price.

Sounds foolish. The thing is, study after study shows that momentum investing works. It works particularly well when it’s twinned with time-tested strategies, like value investing.

The result is funds like iShares MSCI USA Momentum Factor ETF (MTUM). Lots of famous mutual funds rely on the phenomenon, even though you wouldn’t immediately know it judging by the name, like Fidelity Contrafund (FCNTX).

Jason Henry for The Wall Street

Momentum: The tendency to stay in motion.

The question is, why does momentum work? Here’s what AQR Capital’sCliff Asness and three co-authors say in a just-released paper on Social Science Research Network:

One of the myths often said about momentum is that “it has no theory” as those, for instance, who dismiss it as a “hot potato” strategy imply. This is false. Like other robust return premia, such as size and value, there is much debate regarding the explanation behind momentum, and again, like size and value, none of the models are so compelling that a consensus exists on their explanation. Still, there are several reasonable theories.

Most theories fall into one of two categories: risk-based and behavioral. While the jury is still out on which of these explanations better fit the data, the same can also be said for the size and value premia.

The behavioral models typically explain momentum as either an underreaction or delayed overreaction phenomenon (it is of course possible that both occur, making it harder to empirically sort things out). In the case of underreaction, the idea is that information travels slowly into prices for a variety of reasons (e.g., investors being too conservative, being inattentive, facing liquidity issues, or displaying the disposition effect—the tendency to sell winners too quickly and hold onto losers too long). In the case of overreaction, investors may chase returns, providing a feedback mechanism that drives prices even higher.

The other possibility is that the momentum premium is compensation for risk. One set of models argues that economic risks that affect firm investment and growth rates can impact the long-term cash flows and dividends of the firm that generate momentum patterns. The idea is that high-momentum stocks face greater cash flow risk because of their growth prospects or face greater discount rate risk because of their investment opportunities, causing them to face a higher cost of capital. In addition, others argue that the presence of a correlation structure across markets and asset classes of momentum strategies is indicative of a shared economic risk.

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.

Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.